BAUPOST'S KLARMAN: Investors are asking the wrong question about the stock market

Seth Klarman, president and CEO of the The Baupost Group Getty Images/ Scott Olson

Baupost's Seth Klarman, one of Wall Street's most respected investors, says investors are asking "Why sell?" when really they should be asking "How can I afford not to?"

He made the comments in a private letter to clients as the stock market continues to rage on to historic highs.

Baupost is holding roughly 40% of its assets in cash and is returning $2 billion to investors at year end, according to a person familiar with the firm.

The firm's funds made almost no money in the third quarter of this year, but are up about 3% on the year, according to the person familiar with the matter.

The firm took a 12% loss on Qualcomm, a multinational semiconductor and telecommunications equipment company.

Seth Klarman, one of Wall Street's most revered investors and founder of Baupost Group, says investors are asking the wrong question about the raging bull market.

As the stock market continues to hit historic highs, Klarman, in a letter to clients, wrote that investors are ignoring big risks. Volatility remains subdued while stock valuations are pricey. And growth stocks - those that represent high quality companies - are appreciating far ahead of value shares, which tend to trade lower than merited.

Klarman runs Boston-based Baupost Group, one of the world's largest hedge funds with $31 billion, which made nearly no money in the past quarter, per the letter. The firm is up about 3% after fees this year through September 30, according to a person familiar with the numbers.

Klarman's analysis boils down to this: Investors are often asking "Why sell? What would I do with the money?" when really they should be asking, "How can I afford not to sell with the risks I'm taking on?"

Here's how Klarman broke it down in the private letter, a copy of which was reviewed by Business Insider:

"First-level thinking says that a 4% bond is better than a 2% bond, which everyone can see. Second-level thinking is that 4% may be insufficient return for the risk," he said. "The other facet of this thinking is the presupposition that the only relevant opportunity set is the current one."

In other words, those who are tied in to middling investments today might find themselves incapable of taking advantage of more attractive opportunities tomorrow. Klarman didn't specify his cash holdings in the letter, but a person familiar with the firm said Baupost holds about 40% of its assets in cash.

Baupost plans to return a hefty chunk of capital to investors by year's end, meanwhile - about 6% of investors' capital balance as of September 30, 2017 - which is equal to about $2 billion, according to the person familiar with the firm.

Institutional Investor earlier reported about Baupost's letter.

A flat third quarter, and challenges for stock pickers

The firm's funds - which take positions in stocks, private equity and real estate - made almost no money in the third quarter of this year, meanwhile.

Klarman said the firm sold its position in Qualcomm, taking a loss of about 12%, after legal challenges facing Qualcomm's intellectual property proved more difficult to navigate than expected.

"When the market reverses," he wrote, "dormant advantages conferred by analytical edge, discipline, thoughtful hedging, a sourcing network, team building and process improvement are restored."

Klarman says his firm focuses on the long term and that even good investment picks have proven not always to pan out in the short run.

Klarman and his Baupost colleagues are no strangers to warning about the market's risks.

In client letters earlier this year, which were reviewed by Business Insider at the time, Klarman wrote that investors' perceptions of risk were unreasonably muted. He also laid out worries in a separate investor letter, raising red flags about Trump's proposed tax cuts, for instance, which could considerably raise the government's deficit.